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Chapter 12

Capital Flows: Perfectly and Imperfectly

Mobile Capital

Summary In this chapter, the last remaining assumption (that of perfect capital
mobility) is finally relaxed, and the notion of imperfectly mobile capital is
incorporated into our ISLM-BOP model. Several examples demonstrate that the
Keynesian multiplier does indeed exist in an economy characterized by imperfectly
mobile capital.
We discuss the concept of fiscal deficit sustainability, including Rudiger
Dornbusch’s formulation, and review the history of the European Stability Pact
and the European Economic and Monetary Union. We explore today’s real-world
fiscal sustainability issues, including challenges for the USA and the Eurozone.
We will equip ourselves to answer questions such as: how long can capital
inflows finance the monster budget deficits of the USA and at what cost and
implications for the dollar?
Finally, we examine the daily battle in world capital markets between central
banks attempting to implement their desired policies and global investors seeking
opportunities to exploit any weaknesses or imbalances created by policy

12.1 ISLM-BOP with Imperfectly Mobile Capital

While most advanced Western countries allow the free movement of overseas
capital in and out of their economies, many countries, particularly in the developing
world, impose restrictions. In fact, the current dominance of freely floating rates is a
relatively new historical development. Significant restrictions on capital mobility
have been the norm until the globalization era which began in the 1980s. The only
other time in which capital was as unfettered as today was in the decades preceding
World War I.

F. Langdana and P.T. Murphy, International Trade and Global Macropolicy, 291
Springer Texts in Business and Economics, DOI 10.1007/978-1-4614-1635-7_12,
# Springer Science+Business Media New York 2014
292 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Recall that the slope of the BOP line is given by (j/α1). In other words, it is

j Sensitivity of Imports to changes in Output

α1 Sensitivity of Capital Inflow to changes in Interest Rates

With the completely unfettered movement of capital, the variable (α1) is extremely
large, effectively setting the slope to zero, hence the horizontal BOP line under
perfectly mobile capital, which we have been working with up to this point.
When the capital account is closed, i.e., no foreign capital is permitted to move
in or out of the economy, α1 is equal to zero. This makes the slope of the BOP line
infinite; the BOP in this case is a vertical line.
While the post World War II era saw several completely or near-completely
closed economies, notably in the Soviet bloc, few countries today operate with such
total prohibitions on capital movement.
Controls on capital account transactions represent a country’s attempt to protect
itself from the volatility associated with fluctuations in international capital flows,
particularly “hot capital.” A country that finds itself with a balance of payments
surplus or deficit (SFX<>DFX) faces four choices in how it will adjust to a new
1. Allow the exchange rate to adjust.
The practice under freely floating exchange rate regimes. With the depreciation
or appreciation of the exchange rate (e ↑ or ↓), BOP equilibrium is restored by
adjustment of the IS curve.
2. Use foreign exchange intervention to correct the imbalance.
The practice under fixed rates. Foreign exchange flow (FX↑ or ↓) is replaced
with domestic M through foreign exchange intervention, maintaining the
exchange rate but increasing or decreasing domestic money supply. BOP equi-
librium is restored by adjustment of the LM curve.
3. “Sterilize” the foreign exchange inflow to isolate the domestic economy
from the capital flows.
This involves, essentially, replacing the incoming FX with bonds, rather than
money stock. Sterilization will be discussed in detail in Chap. 12.
4. Restrict the flow of capital.
Restricting capital flows reduces the degree to which the IS or LM curves must
move in response to a BOP imbalance. With capital controls in place, BOP movements
accommodate part of the necessary adjustment. Fixed exchange rate regimes often
impose capital restrictions to make the job of maintaining their pegs easier.

Christopher Neely, “An Introduction to Capital Controls,” Federal Reserve Bank of St. Louis
Review (November/December 1999), 5
12.1 ISLM-BOP with Imperfectly Mobile Capital 293

Capital restrictions can take the form of prohibitions or limits on citizens’ ability
to invest in overseas assets, limitations on the classes of domestic assets accessible
to foreign investors (often employed to steer foreign investment in directions
desired by policymakers), excise taxes on different types of inflows (e.g., an exit
tax on any capital withdrawn from the country in the short-term, to encourage
longer-term investments, or a tax on currency conversion, known as the Tobin
Tax2), and so forth. Generally, restrictions on short-term flows attempt to reduce
economic volatility, while restrictions on long-term flows more often relate to
industrial policy goals.
A common effect of these various types of limitations on capital flows would be
to decrease the value of the sensitivity α1, which would increase the slope of the
BOP equilibrium line (from zero, if we are starting from perfect capital mobility).
When capital mobility is imperfect, the BOP line will have a positive slope. If
capital is completely unfettered, then the BOP is depicted as a horizontal line, and
when capital movement is totally prohibited, we obtain a vertical BOP line.
The slope of the BOP will in all cases be less than the slope of the LM line,
which is given by (k/h):

k Sensitivity of Money Demand to changes in Output

h Sensitivity of Money Demand to changes in Interest Rates

The reason this condition holds

k j
h α1
Slope of LM Slope of BOP

. . .is that, generally, the sensitivity of capital inflows to changes in interest rates
(α1) will be higher than the sensitivity of money demand to changes in interest rates
(h). This is because money demand includes a huge domestic component, which is
both slower moving and comes to a great degree from agents whose scope of
activity does not include the choice of foreign versus domestic money.
As well, the sensitivity of money demand to changes in output (k), which is a
direct and immediate relationship, will typically be higher than the sensitivity of
imports to changes in output (j). While the appetite for imports does increase with
output, this takes time, and the utility of imports is small in scale compared with the
utility of money, for which there are countless and immediate uses.

Economist James Tobin proposed the idea of a tax on spot currency conversions as a way to
discourage short-term hot capital flows, which can be destabilizing. Tobin initially suggested the
idea in 1971 and remained a proponent until his death in 2002. Such a tax would effectively
decrease the value of the “α1” sensitivity, which increases the slope of the BOP line.
294 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

This state of affairs, where the slope of the LM curve (k/h) is always steeper than
the slope of the BOP line (j/α1), is an effect of the Marshall–Lerner condition,
named after economists Alfred Marshall (1842–1924) and Abba Lerner
(1903–1982), on whose original ideas the concept is based.3
Under imperfectly mobile capital, many factors become relevant which did not
come directly into play with perfectly mobile capital.
Recall the equations for IS, LM, and BOP:

A þ G þ sY þ eðt þ zÞ ð1 þ b þ jÞ
IS : i ¼ Y
f f
k 1 M
LM : i ¼ Y þ FX
h h P
j α0 i þ α2 Pr  α3 Pr þ α4 ee  ðX  VÞ  sY  eðt  zÞ
BOP : i ¼ Y þ
α1 α1

We can see that with the imperfectly mobile capital BOP, in many cases changes
in variables that work to move one curve will be fully or partially “offset” by
simultaneous, opposite moves in another curve.
For example, a weakening of the domestic currency (e↑) will have the effect of
simultaneously raising the IS line and lowering the BOP line:

½ e " IS BOP
component : component :
þeðtzÞ eðtzÞ
f α1
Result : IS " BOP #

A weakening of the foreign economy (Y*↓) will simultaneously lower the IS line
and raise the BOP:

component : component :
þsY sY
Result : IS # BOP "

The most well-known implication of the Marshall–Lerner condition is that imports and exports
are slow to respond to changing prices and exchange rates, and as a result, currency devaluations
may or may not boost exports relative to imports in the short term depending on relative price
12.2 The Keynesian Multiplier in Action 295


Event IS LM (PMK) (IMK) Event IS LM (PMK) (IMK)
Y* Y*
e e
i* i*
Pr* Pr*
Pr Pr
ee ee

Fig. 12.1 Effect of Δ in variables on IS, LM, and BOP with perfect (PMK) and imperfect (IMK)
capital mobility

And so on. The relative changes will depend on the sensitivities involved. (For
our purposes, as we analyze the generalized effects of various policy changes and
macroeconomic events, specificity regarding the coefficients is not required.)
To the chart summarizing the effects of variable changes on the IS, LM, and
BOP curves that we developed in Chap. 9 (Fig. 9.29), we can now add shifts to the
BOP equilibrium line under conditions of imperfectly mobile capital (Fig. 12.1).

12.2 The Keynesian Multiplier in Action

Recall that when we analyzed the effects of increases in government spending (↑G)
and the money supply (↑M) under a regime of flexible exchange rates and perfectly
mobile capital (PMK) in Chaps. 10 and 11, we obtained the result that there would
ultimately be no increase in output (no ΔY) in either instance. There were side
effects, however, as the ↑G brought about an increase in the current account deficit
and the ↑M brought on inflation (↑P).
Under imperfectly mobile capital (“IMK”), however, due to the positive slope of
the BOP line (which as we noted is caused in large part by the “stickiness” of
changes in the movement of goods versus that of changes in exchange rates and
296 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Fig. 12.2 ↑G, flexible rates,

imperfectly mobile capital

capital flows), we obtain different results. In Fig. 12.2 we examine an increase in

government spending under a regime of imperfectly mobile capital and a floating
exchange rate:
1. G↑ ! IS↑ to IS1.
2. E1 is in BOP surplus, SFX > DFX, e↓.
3. Flexible rates: IS # to IS2 and BOP " to BOP1 : New equilibrium at E2 :
The increase in government initially spending pushes the IS curve higher, to
IS1. This creates a BOP surplus condition, and under flexible rates, the exchange
rate will strengthen (e↓).
Here we depart from the result obtained under perfectly mobile capital, as we
see both the IS curve and the BOP curve responding to the change in the
exchange rate.
4. Results:

Y "; i "; e #
ðAlso X #; V "Þ

Here, in step (3), we see that unlike the result under perfectly mobile capital, the
IS line does not snap all the way back to its starting point and instead meets the BOP
line, which is simultaneously adjusting in the opposite direction. The result is that
the increase in government spending has led to a new equilibrium point (E2) at a
higher level of output and interest rates.
And in the case of an increase in the money supply (Fig. 12.3):
1. M↑ ! LM↓ to LM1.
2. E1 is in BOP deficit, DFX > SFX, e↑.
12.2 The Keynesian Multiplier in Action 297

Fig. 12.3 ↑M, flexible rates,

IMK: Step #1

3. Flexible rates: IS↑ to IS1 and BOP↓ to BOP1. New equilibrium at E2.
4. Results:

Y "; i #; e #
ðAlso X "Þ
The increase in the money stock shifts the LM curve down to LM1. We find the
new IS–LM equilibrium to be in BOP deficit, so the exchange rate weakens (e↑).
This causes the IS curve to shift up and the BOP line to shift down. The new
general equilibrium will be found at some point where they together intersect the
new LM curve.
Two important differences here emerge from the perfectly mobile capital exam-
ple (refer to Fig. 10.8):
1. The increase in output is moderated by the restrictions on capital mobility, which
reduces the propensity of the economy to overheat. We show alternate equilib-
rium point E3, which would have been the new general equilibrium had the BOP
not moved in tandem with the IS. This would have resulted in much higher
output and potential overheating.
2. While inflation will follow from the increase in money supply, as it does under
perfectly mobile capital, the increase in the price level will not take the equilib-
rium all the way back to the starting point. Output will remain higher than
before, as we examine below:
In Fig. 12.4, we show the original curve positions as light gray lines, and the
curve positions resulting from the exercise above, before the increase in the general
price level, as blue lines. Starting at the equilibrium point E2:
1. ↑P ! LM snaps back ↑ to LM2.
2. E4 is in BOP surplus, SFX > DFX, e↓.
298 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Fig. 12.4 ↑M, flexible rates,

IMK: Step #2 – inflation

3. IS adjusts ↓ to IS2 and BOP↑ to BOP2. Final equilibrium at EFINAL.

4. Results:

Y #; i "; and
" P remains
The increase in the price level causes the LM curve to snap back up, to LM2.
Because the new IS–LM equilibrium point E4 is in BOP surplus, the exchange rate
strengthens (e↓). This causes the IS to shift down while simultaneously the BOP
curve shifts up, with a new general equilibrium EFINAL where IS2, LM2, and BOP2
So here, while inflation has moderated the growth, we have still increased output
from where we started (YFINAL versus Y0). This contrasts with the perfectly mobile
capital case where the increase in output was completely offset by inflation.
In these two examples we can see the classic Keynesian multiplier in action.
Increases in government spending and/or money supply are largely spent on
consumption (with the balance saved), with the recipients of that spending then
doing the same, on and on. The total economic activity created by the initial
stimulus may exceed the amount initially spent, raising net output. The main cost
is generally some increase in the price level.
Given an economy with a marginal propensity to consume of 80 % (people
spend 80 cents of every new dollar they earn), the multiplier might hypothetically
function as follows:
12.2 The Keynesian Multiplier in Action 299

↑G by $100 million ↑M by $100 million

1. $100 million goes to infrastructure projects $100 million is issued and is used to
purchase government bonds
from banks
2. The recipients ultimately spend $80 The banks lend out $90 million to
million of their income from the project; businesses, with the $10M balance held as
the rest is saved required reserves
3. The recipients of the $80 million then Those businesses spend and invest
go and spend $64 million (80 %), the $90 million
saving the rest.
4. The recipients of the $64 million then The recipients of the $90 million
spend $49 million (80 %), spend $72 million (80 %), saving the rest
saving the rest.
5. Each subsequent recipient spends 80 Each subsequent recipient spends
% of his or her income. 80 % of his or her income
Total spending from the initial $100 million: Total spending from the initial $100 million:
¼ 80 + 64 + 49 + 40 + 32 + 24 + 17 ¼ 72 + 58 + 46 + 37 + 30 + 24 + 19
+ 13 + 10 + 8 + 6 + 5 + 4 + 3 + 2 + 1 + 15 + 12 + 7 + 5 + 4 + 3 + 2 + 1
¼ $358 million ¼ $335 million
Multiplier ¼ 358/100 ¼ 3.58 Multiplier ¼ 335/1000 ¼ 3.35

As long as the multiplier is greater than one, as it is in these examples, the fiscal
or monetary stimulus will have a positive effect.
In practice, the multiplier is difficult to pin down. Most recent empirical studies
find a lower multiplier than claimed by adherents of the theory (often lower than 1),
but there is still plenty of research supporting a multiplier greater than one.4 Much
of the dispute is clouded due to the fact that adherents and detractors have split
along political lines, with those favoring more government involvement in the
economy citing Keynes in support of their views and those wary of government
involvement in the economy seeking to prove him wrong.

Robert Barro finds a multiplier of between 0.4 and 0.7 in an empirical analysis covering several
decades of data (Robert Barro, Macroeconomic effects from government purchases and taxes,
Mercatus Center, Georgetown University, July 2010), and Cogan and Taylor find a multiplier of
near-zero for the 2009 US stimulus plan due to misdirected spending (Cogan JF, Taylor JB What
the government purchases multiplier actually multiplied in the 2009 stimulus package, October
On the other hand, using New Keynesian methodology, Michael Woodford finds a multiplier
varying from less than one to much greater than one depending on the state of the economy, with a
severely depressed economy being much more responsive (Michael Woodford, Simple analytics of
the government expenditure multiplier, Columbia University, June 13, 2010). And, using Classical
Keynesian analysis, Romer and Bernstein posit a multiplier of 1.4 (Romer C, Bernstein J The job
impact of the American recovery and reinvestment plan, January 9, 2010).
300 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

John Maynard Keynes (1883–1946), Copyright Bettmann/Corbis/AP Images

Regardless, it is clear that whatever its specific value, our analysis has
demonstrated that the Keynesian multiplier operates better under a regime involv-
ing some restrictions on capital flows, as the free movement of capital in and out of
the country can defeat the designs of policymakers. Keynes, in fact, developed his
General Theory in a world of imperfectly mobile capital, fixed or managed
exchange rates, sticky wages and prices, and delayed changes in price elasticities.
Lord Keynes, whatever he might think of his theory’s applicability to today’s
economic world, was never one to shy away from controversy, and would have
certainly been entertained to know that his name would be hurled about by
energized partisans some 70 years after his death.
Whether or not an increase in government spending can stimulate economic
growth, there is an external constraint on the ability to implement such policies. We
have assumed bond-financed deficits in all of our examples so far. Increases in M
have been assumed to occur through traditional monetary policy, typically open-
market operations. Monetization of debt, where the fiscal authority cannot find
buyers for its bonds and turns to the central bank to print money, is another story
entirely. Once that barrier is crossed, it becomes increasingly difficult for a country
to finance itself as potential buyers become increasingly skittish about lending
money to a country that may well inflate away the value of its bonds. An inflation-
ary spiral ensues, which ends badly for all.
To maintain the ability to finance its deficits through bond issuance, investors
must believe that the issuing government will never approach the point where it
resorts to monetization. In the next section, we examine the criteria by which the
sustainability of deficit financing may be evaluated.
12.3 The Dornbusch Model of Sustainability 301

12.3 The Dornbusch Model of Sustainability

12.3.1 Fiscal Deficit Sustainability

In the post-financial crisis era (of 2008–2009) of fiscal constraints brought about by
reduced government revenues resulting from the global recession, the size of fiscal
budget deficits has become a worldwide concern. Most advanced Western
economies today run persistent fiscal deficits, where government expenditures
exceed revenues. However, while several Latin American countries, as well as
several former Soviet satellite states, suffered hyperinflations in the early 1990s,
and while Zimbabwe experienced a mind-numbing hyperinflation from 2005 to
2008, no advanced economy has suffered a rampant hyperinflation since the
Hungarian episode of 1945–1946.
How is this possible if these governments have generally run large and persistent
deficits for decades on end?
The key to understanding the answer is the concept of sustainability. As long as
the fiscal authority can incur a continuously increasing stream of deficits by issuing
new debt to repay the principal and interest of earlier periods, the fiscal deficit is
considered to be sustainable. There is an upper limit on any government’s ability to
incur debt beyond which servicing the debt consumes the entirety of the
government’s resources, beyond which the government must resort to monetiza-
tion. This results in a hyperinflationary spiral of soaring prices, crashing exchange
rates, and the epic destruction of wealth among the country’s citizens.
A “sustainable” deficit-financing policy is defined as one in which an upper limit
of debt financing, characterized by adverse effects on the price level, nominal
exchange rates, and real wealth, is never attained, and the possibility of future
unanticipated monetization to wipe out the debt in real terms is, for practical
purposes, nonexistent.5
So, how much debt is “too much”? What makes a deficit-financing policy
“sustainable”? How can a government know when it is on a path to ruin, in time
to change its course?

12.3.2 Rudiger Dornbusch

With the breakup of the Bretton Woods system of currencies linked to a gold-backed
US dollar in 1971, the world’s advanced economies entered a new and uncharted era
of worldwide fiat money. The interplay between interest rates, now-volatile
currency exchange rates, inflation, and policy became a hot area for study.

Langdana F (1989) Sustaining domestic budget deficits in open economies. Routledge, Oxford,
Chap. 11
302 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Rudiger Dornbusch, Courtesy MIT Museum

Rudiger Dornbusch (1942–2002), a German-born MIT economist, entered this

field with valuable contributions, particularly with regard to inflation-stabilization
policies, debt and deficits, and prices and exchange rates.
One of his most important contributions was on the topic of budget deficit
sustainability. Dornbusch developed a simple but powerful model to indicate
whether a fiscal policy is sustainable or not.

12.3.3 The Dornbusch Model of Fiscal Deficit Sustainability

The ability of a government to continuously finance its debt depends not only on the
size of its budget deficits and outstanding debt but also on interest rates, inflation,
and the growth rate of the economy.
Interest rates affect the country’s cost of debt service, which at high debt-to-GDP
ratios (above 60–70 %) becomes significant. Inflation reduces the real value of
nominal liabilities and thus reduces the real value of the outstanding debt. So, the
proper measure of the interest cost of debt service is the real interest rate, which is
the nominal interest rate minus inflation.
The growth rate of the economy is a major factor in debt service as well. An
economy growing fast enough year after year will “outgrow” its debt burden.
In Dornbusch’s model, the effective cost of debt service is given by the real,
inflation and growth-adjusted interest rate times the outstanding debt:

Effective burden of debt

¼ ðDebt=GDPÞ  ðReal Interest Rate  GDP Growth RateÞ
service as a % of GDP
12.3 The Dornbusch Model of Sustainability 303

(A) For example, if we are given Country A, with

Debt/GDP ratio ¼ 50 %
Nominal interest rate ¼ 5 %
Inflation rate ¼ 4 %
GDP growth rate ¼ 5 %
then the effective burden of debt service ¼ 50 %  ([5  4]  5) ¼ 2 % of
GDP. This means that debt service is not exceeding the economy’s ability to
continuously fund it.
(B) To take another example, if we are given Country B, with
Debt/GDP ratio ¼ 75 %
Nominal interest rate ¼ 10 %
Inflation rate ¼ 4 %
GDP growth rate ¼ 2 %
Here, the effective burden of debt service ¼ 75 %  ([10  4]  2) ¼ 3 % of GDP.
Debt service exceeds the economy’s ability to absorb it through growth and inflation.
Debt service is not the only thing to consider, however, as the primary budget
deficit (government expenses excluding interest, less revenues) adds to the existing
debt burden. So, we must add the primary deficit as a % of GDP in order to obtain a
measure of the total burden of the combined primary fiscal deficit and debt service.
The effective burden of deficit financing is given by:

Effective burden of Deficit

Primary Deficit Effective burden of debt service
Financing as % of GDP ¼ þ

If our primary deficit is 1.5 % of GDP, then for the two countries above:
(A) The effective burden of deficit financing as % of GDP ¼ 1.5 % + (2 %) ¼
0.5 %.
Here, economic growth and inflation are outgrowing the debt that is being
added due to deficit financing. The debt-to-GDP ratio will drop by 0.5 % per
year in Country A. As long as the variables remain in a range close to what was
given, this economy is on a sustainable path.
(B) Here, the effective burden of deficit financing as % of GDP ¼ 1.5 % +
(3 %) ¼ 4.5 %.
This country’s fiscal policy is non-sustainable. The country’s debt-to-GDP
ratio will increase by +4.5 % per year. Persistent adherence to its current policies
will eventually take the debt burden beyond Country B’s ability to service it.
Dornbusch’s formula for fiscal deficit sustainability is given by an algebraic
expression of the formula we described above:

bO ¼ d þ b ðr  gÞ
304 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

if bO < 0, then fiscal deficit policy is sustainable


bO ¼ rate of Δ of ratio

d¼ ratio

b¼ ratio

r ¼ real interest rate

g ¼ growth rate of the economy

The most important independent variable is g, the GDP growth rate. A high
enough rate of economic growth will overcome many sins, as the economy simply
outgrows the effects of even the most profligate fiscal authorities. Stagnant or
negative growth, however, is a killer, as any deficit will be non-sustainable. The
economy must either turn around or the government must find a way to repair its
fiscal situation.6
Naturally, engaging in non-sustainable deficit policy for a short period of time
does not lead immediately to ruin. Most countries will tolerate relatively large
deficits during times of economic contraction and hardship, because (a) revenues
fall when the economy slows, enlarging existing deficits, and recovery is gener-
ally anticipated with a turn in the business cycle, and (b) it is a generally accepted
premise in advanced economies that some social safety net protection is neces-
sary for the displaced during bad times. (A third reason involves the idea that
deficit spending during bad times will stimulate the economy back to optimum
output and employment, per John Maynard Keynes’ prescriptions, but as noted
earlier in the chapter, this notion has become more controversial over recent
years particularly for countries with very high existing debt/GDP ratios.)
The key to deficit-financing sustainability is to maintain a low level of debt/GDP
during the good times, so that the effects of deficit spending on the real fiscal
situation are minimized. (Recall that the debt/GDP ratio is the multiplier used to

The sovereign debt crisis in the Eurozone from 2009–(?) has illustrated this point. Countries with
very high debt/GDP ratios (the b variable) suddenly found themselves entwined in a global
recession, with extremely low or negative growth rates (g). Given the already-high debt ratios,
Eurozone countries did not have the flexibility for their debt to grow during the downturn that they
might have enjoyed were they starting from a lower debt/GDP ratio.
12.3 The Dornbusch Model of Sustainability 305

Country Adopted 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Austria 1999 -2.4 -1.8 -0.2 -0.9 -1.7 -4.6 -1.8 -1.7 -1.0 -1.0 -4.1 -4.5 -2.6 -2.9
Belgium 1999 -0.7 -0.1 0.4 -0.2 -0.2 -0.2 -2.6 0.3 -0.1 -1.1 -5.6 -3.9 -3.9 -3.0
Cyprus 2008 -4.5 -2.4 -2.3 -4.5 -6.6 -4.2 -2.5 -1.2 3.5 0.9 -6.1 -5.3 -6.3 -4.8
Estonia 2011 -4.2 -0.9 0.3 0.9 2.2 1.6 1.6 3.2 2.8 -2.3 -2.1 0.4 1.0 -2.0
Finland 1999 1.7 6.9 5.1 4.1 2.4 2.2 2.7 4.0 5.3 4.2 -2.7 -2.9 -0.8 -1.4
France 1999 -1.8 -1.5 -1.7 -3.3 -4.1 -3.6 -3.0 -2.4 -2.8 -3.3 -7.6 -7.1 -5.2 -4.7
Germany 1999 -1.5 1.3 -2.8 -3.7 -4.1 -3.8 -3.4 -1.6 0.2 -0.1 -3.2 -4.1 -0.8 -0.4
Greece* 2001 -3.2 -3.7 -4.4 -4.8 -5.7 -7.4 -5.6 -6.0 -6.8 -9.9 -15.6 -10.5 -9.1 -7.5
Ireland 1999 2.6 4.7 0.8 -0.5 0.3 1.3 1.7 2.9 0.1 -7.3 -13.9 -30.9 -12.8 -8.3
Italy 1999 -2.0 -0.9 -3.2 -3.2 -3.6 -3.6 -4.5 -3.4 -1.6 -2.7 -5.4 -4.5 -3.8 -2.7
Luxembourg 1999 3.4 6.0 6.1 2.1 0.5 -1.1 0.0 1.4 3.7 3.0 -0.8 -0.9 -0.6 -2.5
Malta 2008 n/a -5.8 -6.4 -5.8 -9.2 -4.7 -2.9 -2.8 -2.4 -4.6 -3.7 -3.7 -2.7 -2.5
Netherlands 1999 0.4 2.0 -0.3 -2.1 -3.2 -1.8 -0.3 0.5 0.2 0.5 -5.4 -5.1 -4.7 -3.7
Portugal 1999 -3.1 -3.3 -4.8 -3.4 -3.7 -4.0 -6.5 -3.8 -3.2 -3.7 -10.2 -9.8 -4.2 -5.0
Slovak Republic 2009 -7.4 -12.3 -6.5 -8.2 -2.8 -2.4 -2.8 -3.2 -1.8 -2.1 -8.0 -7.7 -4.8 -4.8
Slovenia 2007 -0.6 -1.2 -1.3 -1.4 -1.3 -1.3 -1.0 -0.8 0.3 -0.3 -5.5 -5.3 -5.6 -4.6
Spain 1999 -1.4 -1.0 -0.7 -0.5 -0.2 -0.3 1.0 2.0 1.9 -4.2 -11.2 -9.4 -8.9 -7.0

# Countries 11 11 12 12 12 12 12 12 13 15 16 16 17 17
Mean -0.4 1.1 -0.5 -1.4 -1.9 -2.2 -1.9 -0.6 -0.3 -2.0 -6.8 -7.2 -4.5 -4.0
Median -1.4 -0.1 -0.5 -1.5 -2.4 -2.7 -2.2 -0.6 0.1 -1.1 -5.6 -5.2 -4.2 -3.7

Fig. 12.5 Eurozone fiscal deficit % of GDP 1999–2012. Deficits exceeding 3 % of GDP are
highlighted. *Greek figures are restated from the original, contemporaneously reported data
(Data source: IMF)

compute the effective burden of debt service—a high multiplier greatly exacerbates
the effective burden of debt service.)
In practice, despite the elegant models put forth by Dornbusch and other
economists, simple rules of thumb tend to predominate when policymakers and
investors evaluate fiscal deficits.
Generally, if the deficit-to-GDP ratio is less than 3–5 %, then bond-financed
budget deficits in mature economies such as the USA, Japan, and Western Europe
are said to be sustainable. A deficit greater than 5 % maintained for a prolonged
period will attract the close scrutiny of investors, who may shy away—driving up
interest rates and exacerbating the situation with higher interest rates. Under 5 % or
so, it is assumed that the economy will generally grow enough to absorb the added
debt each year.
The European Monetary Union requires, among other criteria, that fiscal deficits
remain under 3 % of GDP. Failure to adhere to this rule invokes penalties. However,
the financial and economic crisis of 2007–2009 resulted in severe drops in govern-
ment revenues, as well as the expenditure of huge sums in crisis-response efforts
including banking system support and fiscal stimulus. Once the crisis hit, the 3 %
rule was simply ignored. In 2010, among the 17 Eurozone countries, only Finland,
Estonia, and tiny Luxembourg maintained budget deficits of 3 % or less of GDP
(Fig. 12.5).
In the next section, we will explore the evolution, historical challenges, and
current predicament of the European currency union and the euro.
306 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

12.4 The European Economic and Monetary Union

and the Euro

The European currency unit, the euro, is the second largest reserve currency in the
world and is as of 2013 the sole and official currency of the 17 Eurozone countries.
It is used and accepted in several others, and some 23 additional countries are
pegged to the euro. The total number of people who use the euro or a currency
pegged to the euro as their primary money exceeds 500 million.
The euro is unusual in that it is a supranational currency, spanning a number of
countries, and it is also unusual in that the money has no single fiscal authority
standing behind it, instead being dependent on agreements in place between
member governments.
The development of the euro was a gradual process that took many decades and
was part of a general drive toward European political and economic integration that
began in earnest following the World War II.
Seminal events in the euro’s evolution:

12.4.1 1946 Churchill: “United States of Europe”

– Small Germany
– Soviet threat
– Specialize and trade freely
In the aftermath of the devastation wrought by the World War II, Winston Churchill
gave a speech at the University of Zurich, in which he proposed closer political and
economic integration of the states of Europe: “We must build a kind of United
States of Europe.” The primary motivations at the time were to foster the rebuilding
of Europe, ensure a constrained Germany, reduce the chance and scope of future
12.4 The European Economic and Monetary Union and the Euro 307

intra-European military conflict, and counter the emerging Soviet threat. The
concept of some kind of European federation of states had been bandied around
since at least the late middle ages.
The end of hostilities had opened a rare window in which Germany was weak
and divided; it had always been the fear of German dominance that had heretofore
held back the other major powers from embracing such a scheme.
Ricardo’s prescriptions to gain the full benefits of comparative advantage
through trade were a driving force behind the move toward economic integration,
with the idea that an integrated market would allow each country to specialize in the
goods that made the best use of its abundant factor(s). By trading freely without
tariffs or other restrictions, Europe would achieve a level of economic prosperity
which had formerly been unattainable.

12.4.2 1957 Treaty of Rome

– Abolish customs duties

– Reduce and unify tariffs
– Facilitate internal trade and transport
Churchill’s vision would begin to take tangible form with the 1957 Treaty of Rome,
establishing the European Economic Community (EEC), which made concrete
progress toward a common market among six Western European nations: Germany,
France, Italy, the Netherlands, Belgium, and Luxembourg. The group would expand
in 1973 with the addition of the UK, Ireland, Denmark, and Norway, and further with
the 1981 addition of Greece and the 1986 additions of Spain and Portugal.
The Treaty of Rome had three primary purposes:
1. Abolish national customs duties
2. Lower intraparty tariffs and replace them with a unified external tariff regime
3. Establish common policies for internal trade and transport

12.4.3 1979 European Economic and Monetary Union

– Era of Stagflation and “Malaise”

– 12 Countries essentially pegged to D-Mark
– Exchange rates held within bands: (+/6 % Sp., It., UK; +/2.25 % Fr., others)
– The era of the ECU begins
The dissolution of the Bretton Woods fixed-exchange rate regime, following the
USA’s abandonment of any pretense of the gold standard in 1971,7 resulted in a
free-for-all in the international currency markets. Several countries (Italy, France,

We will discuss Bretton Woods and the 1971 closing of the “gold window” in the next chapter.
308 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Sweden, and Norway) moved to freely floating rates to gain an advantage in exports
and control over their monetary policy, while several countries remained pegged,
primarily to the dollar.
This was a step backward for the project of European economic integration.
Critics pointed to increased uncertainty in intra-European trade and investment as
well as in relations with trading partners outside Europe. The challenges were
exacerbated by external shocks, such as the oil crises of the early and mid-1970s,
and the stagflation (high unemployment combined with high inflation) that plagued
Western economies of the time. The stagflation episode finally convinced most of
Europe of the futility of the “political business cycle.”
The Economic and Monetary Union (EMU) offered a solution to these new
problems. Several European countries, including the larger economic powers
Germany, France, and Italy, joined together (with others soon following) to establish
the European Currency Unit, or “ECU,” a “basket” comprising the currencies of the
12 European Union member states. The ECU effectively fixed the ratio of the
European currencies relative to one another. The result, due to the economic domi-
nance of Germany and its heavy weighting in the currency basket, was that the
member currencies were, to a large degree, effectively pegged to the Deutsche Mark.
The European Monetary System (EMS) required that each country operate under
an “adjustable peg,” where its currency was fixed but was permitted to float within a
relatively narrow band (2½ % for most countries, +/6 % for Italy, and later,
Spain). The agreement allowed the pegs to be periodically adjusted, allowing
some flexibility. The ECU itself floated against external currencies.
The EMU was not limited to currency issues. Priority was given to harmonizing
regulations and continuation of the work begun under the Treaty of Rome to
transform Europe into a single market.

12.4.4 1985 White Paper

– 300 NTBs to eliminate

– 5 types of major barriers remaining to be overcome
Europe’s early experience with the EMU revealed the affinity for protectionism
among policymakers. Having removed internal tariffs and duties, the member
countries resorted to nontariff barriers (NTBs) to protect favored national industries
and constituencies. The famous 1985 White Paper on the Completion of the Internal
Market,8 issued by the European Council, outlined the challenge:
The elimination of border controls, important as it is, does not of itself create a genuine
common market. Goods and people moving within the Community should not find
obstacles inside the different Member States as opposed to meeting them at the border.

Completing the Internal Market: White Paper from the Commission to the European Council
(Milan, 28–29 June 1985) COM(85) 310, June 1985. (Brussels: Commission of the European
Communities), June 1985
12.4 The European Economic and Monetary Union and the Euro 309

The paper found more than 300 NTBs that were hindering trade and economic
development. The major remaining barriers to economic integration fell into five
1. Artificial standards and licensing
2. Fiscal barriers–divergent tax regimes
3. Borders–physical barriers–motor crossings, etc.
4. Large government procurement contracts awarded to favored groups
5. Medical and pharmaceutical standards differences
The paper recommended action on these remaining barriers to trade and eco-
nomic integration.

12.4.5 1986 Single European Act

– Shift away from “absolute harmonization” to “mutual recognition”

– “Minimal harmonization and mutual recognition”
– If one member country accepts a standard, it’s good for all
The reforms outlined in the 1985 White Paper were largely put into place with the
1986 Single European Act, which encompassed various areas of political, eco-
nomic, and social integration. Most of the NTBs identified in the White Paper were
to be eliminated or otherwise addressed.
An important and fundamental change was made regarding the harmonization of
standards, an area of deep complexity and a source of significant complications for
intra-European business. Previously, the goal had been the absolute harmonization
of standards across the Economic and Monetary Union, where individual national
regulations would be replaced by a unified set of governing standards for various
industries and products. However, this objective proved to be contentious and
unworkable as vested interests in each country prevented consensus.
Rules and standards had become the new tariffs, and absurd but major trade
disputes arose over seemingly trivial details. Germany, for example, had invoked its
1516 Beer Purity law (originally designed to safeguard wheat and rye supplies for
bread bakers) to exclude foreign beer; France and Germany dueled over Germany’s
new labeling regulations, which discriminated against a French liqueur, Cassis, and
Belgium used a rule preventing the sale of certain products without a certificate of
authenticity to exclude Scotch Whiskey.
A solution was found in replacing the goal of “absolute harmonization” with the
principle of “mutual recognition.” Essentially, under mutual recognition, within
the area of the EMU, countries could not prohibit products from their markets based
on noncompliance with local standards, if those products adhere to the national
standards of the country of origin.
This change eliminated many of the disputes and led to a more endogenous
process of standardization across borders, led in large part by voluntary efforts
among leaders in each industry.
310 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

US closes the
gold window EMU
1971 1979
30.00% UK






Fig. 12.6 Inflation in selected European countries 1979–1992

12.4.6 1979–1991 Era of the ECU

– Exchange rate stability

– Inflation under control
– Economic growth
In the years following the 1979 birth of the ECU, the impossible trinity broke the
cycle of inflation and stagnation that had plagued Europe. With fixed exchange
rates and freely mobile capital, policymakers’ hands were kept off the M lever. The
inflation of the 1970s was finally brought under control (Fig. 12.6).
The creation of the ECU also led to a significant reduction in exchange rate
volatility, which had exploded in the post-1971 era (Fig. 12.7).
With inflation subdued, and monetary discipline imposed by the impossible
trinity, economic growth returned to Europe.

12.4.7 End of the ECU

1992 The ECU Blows apart!

12.4 The European Economic and Monetary Union and the Euro 311

0.50% ITL/DEM
Percentage Daily Change





Fig. 12.7 Daily European exchange rate fluctuations 1971–1989 (Average percent daily change
in exchange rates, French Franc, Italian Lira, and Dutch Gulden versus Deutsche-Mark, 1971–89.
The Exchange Rate Mechanism and ECU currency basket were established in 1979. Data source:
St. Louis Fed, authors’ calculations)

In 1989, the German people, along with most of the free world, rejoiced at the
fall of the Berlin Wall, symbol of Soviet oppression and of the 45-year partition of
Germany. The path to German reunification was finally open.
As Germany’s reintegration proceeded toward its October 1990 conclusion, the
issue of the East German currency was one of much debate and discussion. The
Ostmark (the East German mark) had never been convertible, and while the East
German government’s official exchange rate held it at parity with the Deutsche mark
(“DM”), the black-market rate was persistently on the order of 5-to-1 or higher.
In July of 1990 the West German Government announced that Ostmarks would be
accepted for exchange at the rate of 1-to-1 to the DM for the first 4,000 units per
person and the rate of 2-to-1 for larger amounts. This was seen as the best way to
speed along integration and assist the citizens of the former East Germany, who had
suffered through decades of economic retardation under socialism, through the
transition to a modern capitalist economy. On the eve of reunification,
East Germany’s GDP per capita was only 31 % of that of West Germany; its factories,
plant equipment, and infrastructure were technologically obsolete and in a state of
disrepair, and its labor was force ill suited to meet the demands of a modern economy.
While West Germany enjoyed a short-term economic boom thanks to the addition
of 16 million new consumers hungry for better-quality western goods, and the addition
of millions to its labor force, the longer-term economic picture was unclear. Retraining
312 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

such a huge labor force would be a colossal undertaking.9 Modernizing East

Germany’s crumbling and outdated infrastructure would require, for the most part,
pulling it up root and branch and starting over. These efforts would require
incredible sums.
While the German people were euphoric that their nation had finally emerged
from its 1945 division, the Bundesbank, on the other hand, viewed the
developments with great and grave concern—memories of the searing 1922–1923
German hyperinflation were omnipresent.

Top: East Berlin citizens get helping hands from West Berliners as they climb the wall near the
Brandenburg Gate, Nov. 10, 1989, Associated Press. Bottom from left: Woman uses bank notes to
fill a stove, Germany, 1923, Getty Images. This is the way large firms drew the weekly payroll from
the Reichsbank in Berlin, shown Aug. 15, 1923, Associated Press

An old joke among workers in the Soviet Union and its satellite states went: “We pretend to work,
they pretend to pay us.”
12.4 The European Economic and Monetary Union and the Euro 313

Fig. 12.8 France, UK, other

Europe ex-Germany,
expected results post-1990
reunification, ↓Pr*, fixed
rates, PMK

The German government’s acceptance of East German money at a 1-to-1

conversion ratio amounted to an enormous transfer of wealth from West to East.
This, combined with other payments, would equate to a subsidy of between
150 billion and 200 billion DM per year, representing around 6–8 % of West
German GDP. The Bundesbank observed with alarm that under the original plan,
money supply was projected to shoot up by +20 % in 1991, and the fiscal budget
deficit was expected to expand substantially. Inflation loomed.
The Bundesbank was not the only party to be somewhat wary of the
consequences of reunification. It was never far from the collective memory of
other European nations, France and the United Kingdom in particular, that
Germany had twice in the twentieth century attempted the domination of Europe;
the leaders of these countries had once been children suffering under German air
raids and occupation. While unification was seen as inevitable, it was often viewed
skeptically by those suspicious of unchecked German power.10
Despite the fact that most Western economies at the time were in an economic
slump and headed toward recession, the immediate economic effects of reunifica-
tion on the rest of Europe were not a major concern. From the perspective of France,
the UK, and other European countries, while the economic uncertainty and
challenges facing Germany clouded that country’s long-term economic outlook
(Pr*↓), the effects of this on the other European economies would be benign
(refer to Fig. 12.8):
1. Pr*↓(Germany) ! BOP↓ to BOP 1.
2. E0 is in BOP surplus, SFX > DFX, fixed rates: FX↑.
3. LM adjusts ↓ to LM1, new equilibrium at E1.
4. Results: Y "; i # :

Regarding German reunification, British Prime Minister Margaret Thatcher reportedly told
Soviet Premier Gorbachev: “All Europe is watching this not without a degree of fear, remembering
very well who started the two world wars.”
314 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Fig. 12.9 France, the UK, other Europe, foreign (German) interest rates shooing up (i*↑↑) (a)
Hold the peg (LM↑) or (b) break the peg (IS↑)?

In Fig. 12.8, the “domestic economy” is a combination of France, the UK, and
the rest of Europe excluding Germany. We see the foreign (Germany) macro
outlook falling, which pushes the BOP line down to BOP1. Since we are under a
fixed-rate regime, this results in an inflow of FX, which moves the LM line down to
LM1. The new equilibrium is at E1, with the benign result of lower interest rates and
higher output.
The rest of Europe would benefit, to some extent, from the uncertainty
surrounding the economic effects of German reintegration as capital migrated to
their less risky economies.
However, shockingly, in the midst of Germany’s celebration, the Bundesbank
sent a powerful signal to the German fiscal authorities: “We will not monetize
your runaway deficit!” The central bank raised interest rates sharply, to above 9 %
through 1991–1992 in an attempt to keep inflation in the bottle.
While this move was met with fierce objections from the German fiscal and
political authorities, the turmoil in Germany was nothing compared with the horror
with which the policy was greeted among the rest of the EMU countries. The savage
increase in German interest rates had turned their formerly sunny economic horizon
into a decidedly bleak landscape.
European Monetary System members faced a stark choice: (a) remain pegged
under the ECU, or (b) de-peg their currencies and leave the ECU.
Both choices start with foreign interest rates having soared, pushing the BOP
line upward (see Fig. 12.9):
12.4 The European Economic and Monetary Union and the Euro 315

(a) Remain pegged under the ECU (b) De-peg and leave the ECU
(1) i*↑↑ (Germany) ! BOP↑↑ to BOP1 (1) i*↑↑ (Germany) ! BOP↑↑ to BOP1
Decision: Keep the Peg! Decision: Break the Peg!
(2) E0 is in BOP deficit, DFX > SFX, FX↓ (2) E0 is in BOP deficit, DFX > SFX, e↑
(3) LM adjusts ↑ to LM1, equilibrium at E1 (3) IS adjusts ↑ to IS1, equilibrium at E2
(4) ☹ Results: (4) ☺ Results:
Y↓↓, i↑↑ Y↑, i↑

If they remained tied to the peg (“a” in Fig. 12.9), the other EMU countries
would face contagion from the German situation as FX drained away chasing the
higher returns available in Germany, forcing these countries to raise their own rates
and driving them into a brutal recession. Output would contract, and these countries
would be stuck with an overvalued currency (relative to the rest of the world) and
high interest rates. The UK was the most vulnerable of these economies as its
exchange rate was fixed at a relatively strong rate, making it harder to defend.
As we see in our ISLM-BOP analysis, the economically sound decision would
appear to be to simply permit the currency to float (“b” in Fig. 12.9), which would
relieve the pressure and result in higher output, albeit with higher interest rates.
However, to break the ECU peg was politically unthinkable; it was to reverse the
European project itself. So, the UK raised interest rates and committed FX reserves
to hold its peg. However, as time progressed, the once unthinkable option of
breaking the peg became thinkable. Investors with assets denominated in Sterling
(GBP) became skittish, anticipating a devaluation, and moved to reduce their
exposure. Speculators (including financier George Soros and his Quantum Fund),
believing that the devaluation of the weaker ECU currencies was inevitable, began
to pile on, shorting these currencies and adding to the immense pressure that they
were already under.
By 1992, the ECU, symbol of European integration and stability, had become an
anchor threatening to take down the economies of Europe. The UK, which had only
formally joined the EMS in 1990 after a 10-year period of “shadowing” the ECU
under a semiofficial peg, was spending considerable resources defending the
British pound, a task that was becoming more difficult by the day. The British
had joined the EMS at an inopportune time, with the result that the pound was the
most strenuously overvalued among European currencies and the most subject to
Finally, in 1992, having spent $27 billion of its reserves in a futile attempt to
defend the currency, the British de-pegged! The pound underwent a sharp
depreciation, and Britain avoided the worst of the recession. Germany was on its
own, and the ECU was badly wounded. While no other country formally left the
European Monetary System, Italy broke through its trading band during the crisis,
and Spain and Portugal ultimately devalued their currencies against the mark.
Having breached the perimeter, speculators turned their attention to the inner
citadel, as finally the French franc came under heavy attack. The governments of
Germany and France coordinated a valiant defense, but in the end, the French
resigned themselves to a devaluation. Post-crisis, ECU trading bands were
316 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

broadened considerably (to as much as +/15 %) to provide greater flexibility, but

this served to dilute the effectiveness of the entire system. By 1994 strict adherence
to the exchange rate mechanism came to be seen as more optional than mandatory.
The ECU was a smoldering remnant of its former self.

Illustration by Ricardo Paredes

12.4.8 1999 The Euro

– Single currency
– European Central Bank
On January 1, 1999, the euro was formally launched as an accounting currency
legal for all transactions within its area of acceptance, replacing the ECU at a 1:1
conversion ratio. Actual paper and coin currency would be issued in 2002, when
the euro entered circulation and would formally replace the national currencies of
the participating countries. The formal launch of the euro as a circulating currency
was the final outcome of a process that had commenced concurrently with the
ECU crisis of the early 1990s, which began with the adoption of the Maastricht
treaty in 1992.
The Maastricht treaty established the convergence criteria for a country to
participate in the European Monetary Union:
1. Inflation within 1.5 % of the lowest three countries of the European Union for at
least 1 year
2. Long-term interest rates within 2 % of the lowest of the EU countries for at least
1 year
3. Consistent maintenance of the national currency within the bands of the
exchange rate mechanism (ERM) for at least 2 years
and, most important:
4. Budget deficit-to-GDP ratio of not more than 3 %
5. Government debt-to-GDP ratio of not more than 60 %
The Maastricht treaty led to the establishment of the Stability and Growth
Pact, which codified the last two fiscal requirements as ongoing criteria for
continued participation in the EMU, and set penalties for noncompliance.
12.4 The European Economic and Monetary Union and the Euro 317

In 1998, the European Central Bank (ECB) was established in Frankfurt, signal-
ing that German monetary discipline would be the fundamental philosophy
undergirding the new currency. In that same year, the conversion ratios of the
11 participating currencies were fixed.
With the adoption of the euro, European economic policy entered new and
uncharted territory. Never before had a major supranational currency been created
without a single fiscal authority standing behind the central bank. Instead, capitali-
zation of the ECB was pro rata, based essentially on relative GDP, and each country
maintained control over its own fiscal policy. The weaknesses inherent in this
situation were noted at the time, but were largely dismissed. These would become
glaringly apparent less than 10 years later.

12.4.9 2010–? European Sovereign Debt Crisis

– Greece, Ireland, Spain (and Italy, Portugal?) ! non-sustainable

– Euro under pressure
The euro performed well for the first several years after its launch, steadily gaining
value against the US dollar and holding its own against other currencies.
The financial crisis of 2008 brought the first indications of trouble. Despite its
good reputation, the young currency at this time was still, to an extent, unproven. In
the panic investors seeking safe haven scrambled to hold US dollars as the euro fell
(Fig. 12.10).
As the acute phase of the crisis eased, the euro rebounded. However, as the
global recession set in, revenues of governments around the world at all levels, from
the central authorities to municipalities, dropped precipitously as economic activity
slowed down. Those governments that had spent lavishly during the good times
found themselves with unmanageable deficits, and their debt exploded from
pre-crisis levels.
The Greek situation was the most precarious. Greece’s tradition of large public
deficits to finance generous social benefits resulted in a debt-to-GDP ratio perpetu-
ally exceeding 100 %. Prior to the adoption of the euro, persistent depreciation of
the exchange rate had been one way Greece managed to persist with this policy.
(The mechanism driving depreciation would be, in our language, as follows:
Domestic long-term outlook is poor [Pr↓], which raises the BOP line, leaving us in
BOP deficit (DFX>SFX); under a floating rate regime, this will cause the exchange
rate to weaken [e↑].)
Upon the adoption of the euro, currency devaluation was no longer an option;
however, the single currency, under the prudent management of the ECB, allowed
Greece to borrow at more favorable interest rates than would have been available
318 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

USD/EUR, Feb 2002 - Sep 2012

(a)(b) (c) (d) (e)
Fig. 12.10 The USD/EUR exchange rate and the euro crisis 2010–? (Exchange rate data source:
OANDA.com) ((a) July 2008 USD 1.58/EUR: Onset of acute phase of US Financial Crisis.
Treasury initiates support for Fannie Mae, Freddie Mac. Indymac Bank fails (b) Nov 2008 USD
1.27/EUR: TARP passes, adding US $700 Billion fiscal support on top of the unprecedented
Monetary expansion and Fed guarantees of Sep–Nov 2008 (c) Nov 2009 USD 1.49/EUR: First
signs of serious trouble in Eurozone as Greece admits to fiscal deficit of 12.7 % of GDP, double its
previous claims (d) Jun 2010 USD 1.22/EUR: European Financial Stability Facility launched June
9, 2010 with total facilities of EUR 750 Billion (e) Oct 2011 USD 1.37/EUR: EFSF expanded,
Greek debt write-down, Nov 2011 coordinated global central bank action, Dec 2011 ECB begins
LTRO operations of nearly EUR $500 Billion)

otherwise.11 Capital flowed in from investors seeking higher returns than were
available on German or French bonds, and the economy grew.
The global recession drastically affected the Greek economy. Greek government
revenues, heavily dependent on tourism and shipping, sagged. Investors began to
seriously question the sustainability of Greek fiscal policy. In the midst of the
turmoil, it emerged that Greece had misrepresented its true fiscal picture through
various derivative transactions12 at the time of its adoption of the euro, in order to
qualify itself under the Maastricht criteria. Yields on Greek bonds shot up over
15 %, and the country faced a debt crisis.

The reason why this should be the case is not immediately obvious, as investors were certainly
aware that despite externally imposed monetary prudence, each country within the Eurozone was
in full control of its own fiscal policies. Confidence in mutual adherence to the Maastricht criteria,
or perhaps that even in a crisis, the strong countries (Germany and France) would almost certainly
“bail out” the weaker rather than permit a default, are plausible explanations.
Reportedly aided by the US investment banks, primarily Goldman Sachs. Beat Balzli, “How
Goldman Sachs Helped Greece to Mask its True Debt,” Der Spiegel, February 8, 2010
12.4 The European Economic and Monetary Union and the Euro 319

In such a crisis, under a pegged regime, speculative attacks on the currency

would normally ensue, which would end with the peg being broken. The
depreciated currency would spur exports and economic activity generally, and the
“cheaper” domestic currency denominated debt would be easier to repay.
This was not an option for Greece under the single European currency. The
country, like others on the periphery, found itself trapped with a currency that was
too strong. Even were Greece to consider the drastic step of leaving the euro, it
would still be left with its debt denominated in euros, the vast majority of which was
foreign held. Also to be considered was the vast reordering of its economy that
would be required in order to achieve a return to a national currency. Such a move
would, by the terms EU membership, require that Greece leave the EU itself.

Greeks register their opinion of the first austerity plan (with several to follow), Athens, February
24, 2010. Associated Press

A combination of austerity measures, which brought thousands of protesters to

the streets, and a series of “final” rescue packages from the Eurozone and the
International Monetary Fund (IMF),13 temporarily staved off a succession of crises.
As of this writing, many observers believe that the Greek debt has passed beyond
the country’s ability to repay and will ultimately need to be restructured.

The first rescue fund of €110 billion was implemented in May 2010 by the IMF, the ECB, and
the Eurozone members, and a second fund of €130 billion, funded by the Eurozone countries, went
into effect in February 2012. Additional rescue funds and mechanisms have been proposed.
320 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Fig. 12.11 Greece Government bond 10Y, implied yield on 10-year bonds (Source: www.

Under the supranational currency, rather than speculative attacks on the mone-
tary unit, a crisis in confidence affecting a particular country manifests itself in
flight from that country’s sovereign bonds. Yields on Greek bonds were blowing
sky high until the first rescue package was announced in 2010, and while down from
their peaks, remained elevated from their pre-crisis levels and would eventually
explode in 2011–2012 as the crisis rolled on (Fig. 12.11).
From Greece, investors’ attention next turned to Ireland, which had made the
decision during the 2008 financial crisis to fully guarantee its banks debts. This was
far too much debt to take on for such a small country. By 2010 it was clear that
without an emergency source of funding, Ireland, with an astounding 2011 fiscal
deficit of 34 % of GDP, faced default.
Concerns were raised about other European countries also on shaky fiscal
footing: Spain, Portugal, and Italy, which, along with Ireland, faced budget deficits
near or exceeding 10 % of GDP, had all seen their debt skyrocket starting in 2008
(Fig. 12.12).
Facing what threatened to escalate into a Europe-wide series of defaults, in May
of 2010 the European Union, the IMF, and the European Central Bank moved to
establish facilities of sufficient size, totaling €750 billion, to credibly signal a
commitment not to let any member country default. An €85 billion rescue package
was negotiated for Ireland in November of 2010. Market fears cooled for a time,
with yields across Europe still elevated but significantly down from their peak. New
concerns arose in early 2011 with the fall of several governments that had
implemented austerity measures; investors’ initial reaction to these developments
was to once again shun these countries’ debt.
Coordinated action on the part of European authorities from late 2011 onward,
including expansion of the EFSF, massive intervention by the ECB,14 and a series

This intervention included direct purchases of Spanish and Italian bonds starting in August 2011
and some €500 billion in long-term refinancing operations (LTRO) starting in December 2011,
where the ECB provided the continent’s banks with 3-year loans and allowed the banks to use
sovereign debt as collateral.
12.4 The European Economic and Monetary Union and the Euro 321

European Gross Debt to GDP 1997-2012,

selected countries
100 Ireland
80 Portugal

Fig. 12.12 European Gross Debt to GDP 1997–2012, selected countries (Data Source: IMF)

of extensions and concessions on previously negotiated terms with bailout

recipients, has allowed the euro “to be kicked down the road” much longer than
many analysts and economists anticipated. The precariousness and uncertainty
surrounding these interventions was highlighted in late 2012 when the credit rating
of the ESFS itself was downgraded due to concerns about France, its second-largest
Regardless of what occurs in the short term, the overhang of debt across Europe
is nearly overwhelming, and it is unclear as of this writing if and in what manner
sovereign debts across the region will ultimately be restructured.

12.4.10 The Future of the Euro

This episode has exposed important shortcomings of the single European currency,
which can be boiled down to:
Single currency + Independent national budgets ¼ Massive fiscal deficits
Single monetary policy + Fixed exchange rate ¼ Persistent trade imbalances
and high unemployment15
With the single European currency came a uniform European monetary policy.
This allowed the national governments of the smaller and weaker states on the
periphery, including Greece, Ireland, Italy, Portugal, Spain, and Belgium, to borrow

A concise contemporary debate on the euro’s future may be found in “The Euro’s Debatable
Future,” Wall Street Journal, March 8, 2011.
322 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

at more favorable rates of interest than would have been available to them otherwise,
and these countries ran persistent deficits and accumulated huge amounts of debt.
However, the inflow of capital masked underlying economic weakness, which
became exposed once the business cycle turned (in this instance, with a vengeance).
The weaker countries found themselves hopelessly indebted and saddled with a
currency too strong for their fiscal and economic circumstances. The result has been
high unemployment and persistent export weakness. The euro regime, in its present
form, makes macroeconomic recovery significantly more difficult for these states.
On the flip side of the equation are the Germans, who have benefited from the
euro as it is weaker than would be the German mark floating on its own. This has
boosted Germany’s export sector and fueled growth and has made it that much
harder for countries such as Italy and Greece to compete in world markets against
their powerful neighbor (who already leads them in productivity).
A unified currency works over a large geographic area when that area is
culturally uniform and economically integrated, with a highly mobile (or poten-
tially mobile) workforce. This has been largely true of the USA since its inception16
and especially over the last century. The Euro area, however, is united neither in
language nor culture, and while travel within Europe is unrestricted, these
differences form significant barriers to migration. And, while Europe’s economic
cycles have increasingly synchronized, the individual economies remain far more
diverse than those of any of the 50 US states. Finally, labor mobility within the euro
zone, while increasing, is nowhere near the labor mobility found within the USA.
Should the crisis worsen, resolution will depend on German willingness to foot
the bill, as it is the only European country with the economic and fiscal clout to deal
with the situation. While macroeconomic analysis can inform us what the likely
results are of various policy initiatives, ultimately, as often in these cases, the final
decision will be a political one.
Political policymakers and central bankers, however, are not the only players with a
say in the global macroeconomy. The best laid plans of fiscal and monetary authorities
often run aground as seas of capital ebb and flow around them, driven by investors
perpetually scanning the world economy for any opportunity that they may exploit.
This is the focus of our next section.

12.5 Speculative Attacks and Overshooting

12.5.1 Speculative Attacks

Global investors, particularly those managing what is considered “hot capital”—

funds that move quickly to the areas of the world with the best relative

In the 1800s, disputes often arose between the agrarian states, which preferred easier monetary
policy that would lighten their burden of debt and support exports, and the eastern bankers and
industrialists who preferred a “hard money” regime.
12.5 Speculative Attacks and Overshooting 323

opportunities—are keen to anticipate changes in exchange rates and will shift

capital at the first sign of opportunity or trouble.
With billions under management, even minor fluctuations in interest and
exchange rates offer the possibility of extraordinary gains or losses to large institu-
tional investors and “global macro” hedge funds. The biggest opportunities present
themselves when a pegged currency is perceived to be weaker than the official
exchange rate and is under pressure.
Speculative attacks generally begin with a currency crisis arising from a combi-
nation of an artificially strong currency, unfavorable economic factors, and poor
policy decisions. Non-sustainable budget deficits, the impending bursting of specu-
lative asset bubbles, major bank failures, changes in government, or some external
shock17 may undermine confidence in a currency.
When this happens, investors holding assets denominated in the currency run for
the exits, in order to preserve their capital. Very often, the currency crisis becomes
self-reinforcing and self-fulfilling, as no one wants to be left holding the currency
after it has been devalued.
Into this environment come the currency speculators, seeking to profit from the
now-inevitable revaluation. These investors will “short” the weakening currency by
borrowing it and selling it (exchanging it for another currency, in which they lend at
short-term rates), in the anticipation that when they repay the loan, the currency will
have declined significantly in value so that it may be repurchased at a fraction of the
original price.
Taking the 1992 European currency crisis as an example, the exchange rate of
the British pound in August 1992 was approximately $1.90 to £1 GBP (for the UK,
e ¼ [1/1.90] ¼ 0.526). This was already perceived to be a stronger rate than would
prevail under floating exchange rate conditions, and with German reunification and
the Bundesbank’s savage increase in interest rates, questions were raised whether
Britain would send itself into a deep recession simply to preserve its currency peg.
Very often, the seed of doubt is all that is required to sprout a vicious cycle.
The British raised interest rates as high as 15 % and spent some $30 billion in
foreign exchange reserves in an attempt to preserve the value of the pound,18 all of
which came to naught. On September 16, 1992, the UK formally left the EMU and
allowed its currency to adjust. The results were dramatic. The pound immediately
declined in value, falling to $1.65 in October and all the way to around $1.40 to the
USD within 5 months.
A speculator operating with US $1 billion might execute these transactions:
(a) Borrow UK £526.3 million for 30 days at 15 %.
(b) Convert the UK £526.3 million to US $1 billion at the rate of 1.9:1.

For example, the UK currency crisis of 1992–1993 was precipitated by German reunification,
and the Russian Ruble crisis of 1998 was caused in part by a sharp drop in the price of oil.
As we have reviewed throughout, as domestic currency holders rush to convert their currency,
their selling pressure which would otherwise weaken the exchange rate must be taken up by the
Central Bank that purchases the domestic M with its reserves of FX.
324 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

(c) Buy US $1 billion short-term US T-bills at the then-prevailing rate of 3 %.

If our speculator’s timing was right, she would then, upon the devaluation:
(a) Redeem the T-bills for US $1.0025 billion.
(b) Convert US $879.3 million of the proceeds into UK £532.9 million at the new
rate of 1.65:1.
(c) Repay the UK loan with the £532.9 million.
Her profit would be US $123.2 million.
This is, roughly speaking, what George Soros famously did in 1992, but with $10
billion, earning more than $1 Billion in profit.
When currency speculators enter the fray, the volume of transactions exerts
additional pressure on the currency. With enough pressure, the defender’s reserves
will be depleted and the currency will crash. This is a speculative raid or speculative
attack. While the term implies collusion, in fact these operators are all watching the
same data extremely closely, and the simultaneous and seemingly coordinated raids
are simply the result of individual managers smelling blood in the water, rather than
the result of any overt coordination.19
A country facing a speculative attack basically has three choices:
1. Defend the exchange rate by buying its currency using FX reserves
2. Raise interest rates sufficiently high to retain and attract capital
3. Allow the currency to depreciate
Empirical research shows that the second option, while undertaken in almost
every case as part of the defensive strategy, is uncorrelated with success or failure in
repelling speculative attacks.20 Since most currency crises resolve themselves over
a very short time horizon of a few months at most, raising short-term interest rates
even as high as 20 % per annum or more offers investors slight return over horizons
of only few months by comparison with what they risk should a devaluation occur.
To the speculator, 6 % interest to borrow the currency for three or four months is a
small price to pay when the potential returns are so large. Even the extraordinary
1992 Swedish increase in short-term rates to over 500 % could only temporarily
postpone devaluation, as such an unsustainable policy is perceived as a sign of
desperation rather than as a sign of commitment.
The key determinant in the success or failure of a speculative attack is the central
bank’s reserve of foreign currency. Once a country with an artificially strong
currency runs out of foreign exchange to sell (buying its own currency to prop up
its price), the game is over. During the 1997–1998 Asian crisis, Hong Kong
successfully defended its peg because it started with a huge $80 billion pool of

This is not to say that overt coordination does not happen. In many of these instances, however,
overt coordination is not required in order for active market participants to all see the same
potential weakness in a given currency.
Aart Kray, “Do High Interest Rates Defend Currencies During Speculative Attacks?” World
Bank, December 2001
12.5 Speculative Attacks and Overshooting 325

FX reserves to call upon and demonstrated that it was willing to use it. Hong Kong
would deploy some US $15 billion of reserves in its successful defensive operation.
The study of currency crises has advanced over recent decades. The “first
generation” models of the late 1970s and 1980s predicted that investors observing
deteriorating fundamentals will bet on a devaluation and assumed that the
authorities would expend all their reserves in an effort to defend their currency
peg. “Second-generation” models, developed in the mid-1990s, added game-
theoretical implications, where generally speaking investors may attack a currency
if they believe other investors are likely to do so. The currency’s government is part
of the equation, as these models take into account the fact that the authorities may
see a threat developing, deem their reserves to be inadequate to the task, and
preemptively devalue.21
“Third-generation” currency crisis models of the late 1990s incorporate the
banking system as a key player. In these models, bank liabilities are considered
by investors in evaluating a currency’s fundamentals, given the likelihood that in a
crisis, the central authorities are likely to assume responsibility for their banks’
debts. A seminal third-generation paper from 2000 succinctly anticipated the
essence of the Icelandic banking crisis of 2008, which we discussed in Chap. 8:
“In a world with government guarantees, it is optimal for banks to have an
unhedged currency mismatch between their assets and liabilities. When a devalua-
tion occurs, banks simply renege on foreign debt and go bankrupt.”22
Speculative raids generally accompany any currency crisis where capital move-
ment is not restricted and the opportunity exists to enter into a trade. High-profile
cases from recent memory include the 1994 Mexican peso crisis, the 1998 Ruble
crisis, and the Argentinean crises of 2000–2002.
In fact, these actions occur with surprising frequency. A partial list of successful
and unsuccessful speculative currency attacks for the period 1975–2000 reveals
192 attacks, of which 78 were successful while 114 failed (Fig. 12.13):

12.5.2 Overshooting

Very often, a successful speculative currency attack will result in a depreciation

below the presumed long-run equilibrium level of the currency.
We may illustrate overshooting with a hypothetical example.

Olson O, He M (1999) A model of balance of payment crisis: the strong currency as a
determinant of exchange rate disequilibria. Nova Southeastern University, Fort Lauderdale
Burnside C, Eichenbaum M, Rebelo S (2000) Hedging and financial fragility in fixed exchange
rate regimes, Financial Institutions & Market Research Center, Kellogg School of Management,
Northwestern University, Evanston
326 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Speculative Currency Attacks 1975-1999

Cur Year Outcome Cur Year Outcome Cur Year Outcome Cur Year Outcome Cur Year Outcome
ARG 1975 Successful BOL 1979 Successful MUS 1982 Failed JOR 1988 Failed FRA 1993 Failed
BWA 1975 Successful CRI 1979 Failed ZAF 1982 Failed SWE 1988 Failed IRL 1993 Successful
DNK 1975 Failed FIN 1979 Failed IDN 1983 Successful TTO 1988 Failed NAM 1993 Failed
IDN 1975 Failed FRA 1979 Failed JAM 1983 Successful DNK 1989 Failed PNG 1993 Failed
NAM 1975 Successful MUS 1979 Successful KOR 1983 Failed GRC 1989 Failed TTO 1993 Successful
PER 1975 Successful NLD 1979 Failed PHL 1983 Successful GTM 1989 Successful URY 1993 Failed
PRT 1975 Failed NOR 1979 Failed BWA 1984 Successful IRL 1989 Failed DOM 1994 Failed
TUR 1975 Failed NZL 1979 Failed CAN 1984 Failed ISR 1989 Successful MEX 1994 Successful
ZAF 1975 Successful TUR 1979 Successful NAM 1984 Successful KOR 1989 Failed MEX 1994 Failed
ZAF 1975 Failed USA 1979 Failed NZL 1984 Successful PRY 1989 Successful MUS 1994 Failed
AUS 1976 Successful BEL 1980 Failed PRY 1984 Successful BOL 1990 Failed PNG 1994 Successful
BEL 1976 Failed DOM 1980 Failed THA 1984 Successful CAN 1990 Failed THA 1994 Failed
CAN 1976 Failed FIN 1980 Successful THA 1984 Failed DOM 1990 Successful TTO 1994 Failed
DNK 1976 Failed ITA 1980 Failed VEN 1984 Successful FIN 1990 Successful ARG 1995 Failed
DOM 1976 Failed KOR 1980 Successful ZAF 1984 Successful ITA 1990 Failed COL 1995 Failed
FIN 1976 Failed KOR 1980 Failed ECU 1985 Successful PRT 1990 Failed ESP 1995 Successful
JAM 1976 Failed MAR 1980 Failed PRT 1985 Failed SWE 1990 Failed VEN 1995 Successful
MEX 1976 Successful MYS 1980 Failed THA 1985 Failed THA 1990 Failed FIN 1996 Failed
MUS 1976 Failed SWE 1980 Failed TTO 1985 Successful FIN 1991 Successful KOR 1996 Failed
NLD 1976 Failed ZAF 1980 Failed BEL 1986 Failed FIN 1991 Successful BRA 1997 Failed
NOR 1976 Failed ARG 1981 Successful IDN 1986 Successful HKG 1991 Failed GRC 1997 Failed
SGP 1976 Failed BOL 1981 Failed IRL 1986 Successful IDN 1991 Failed GTM 1997 Successful
SWE 1976 Failed CAN 1981 Failed IRL 1986 Failed SWE 1991 Failed IDN 1997 Successful
SWE 1976 Failed CRI 1981 Successful ITA 1986 Failed TUN 1991 Failed KOR 1997 Successful
ZAF 1976 Failed ITA 1981 Failed MYS 1986 Failed ARG 1992 Failed PHL 1997 Successful
ESP 1977 Successful MUS 1981 Successful NOR 1986 Successful BEL 1992 Failed THA 1997 Successful
FIN 1977 Successful MYS 1981 Failed PHL 1986 Failed BOL 1992 Failed BWA 1998 Successful
ISR 1977 Successful NLD 1981 Failed PRY 1986 Successful BWA 1992 Successful DNK 1998 Failed
PER 1977 Successful ZAF 1981 Failed TUN 1986 Failed ECU 1992 Successful FIN 1998 Failed
SWE 1977 Successful AUS 1982 Failed VEN 1986 Successful GBR 1992 Successful GRC 1998 Successful
TUR 1977 Successful BEL 1982 Successful BOL 1987 Failed ITA 1992 Successful HKG 1998 Failed
AUT 1978 Failed BOL 1982 Successful DNK 1987 Failed NOR 1992 Failed MEX 1998 Successful
CAN 1978 Failed DOM 1982 Failed DOM 1987 Successful SWE 1992 Successful NAM 1998 Successful
IDN 1978 Successful ECU 1982 Successful ESP 1987 Failed THA 1992 Failed PNG 1998 Failed
JAM 1978 Successful ESP 1982 Successful ITA 1987 Failed DNK 1993 Successful SWE 1998 Failed
THA 1978 Failed FIN 1982 Successful JOR 1987 Failed DNK 1993 Failed URY 1998 Failed
AUS 1979 Failed GTM 1982 Failed PER 1987 Successful FRA 1993 Failed ZAF 1998 Successful
AUT 1979 Failed MAR 1982 Failed GRC 1988 Failed IRL 1993 Successful BRA 1999 Successful
BEL 1979 Failed MEX 1982 Successful IDN 1988 Failed NAM 1993 Failed MUS 1999 Failed

Fig. 12.13 Speculative currency attacks, 1975–1999. Successful attacks are defined as large
depreciations preceded by a period of stable fixed exchange rates. Failed attacks are defined as
downward spikes in reserves accompanied by upward spikes in short-term default risk, which are
not followed by devaluation within 3 months (Source: “Do High Interest Rates Defend Currencies
During Speculative Attacks?” Aart Kray, World Bank, December 2001)

The Belize (BZD) dollar has been pegged to the US dollar since 1978 at the rate
of 2:1. The currency is generally considered to be slightly stronger than the rate
implies and trades in range of BZ$1.90 to BZ$2.00 to US $1.
Let’s say that a combination of a steep worldwide drop in the price of sugar, the
country’s main export, the threat of a change in government over to a radical party
with an uncertain outcome, and a sharp decline in tourism due to this political
uncertainty puts the BZD’s 2:1 USD peg under pressure. Market experts evaluating
the situation estimate the fair value of the BZD at perhaps 2.6–1 USD, were it
permitted to float. Nervous investors sell their BZD-denominated financial assets
where they can and undertake expensive hedges where they can’t. Speculators pile
in, adding to the pressure.
12.5 Speculative Attacks and Overshooting 327

Fig. 12.14 Overshooting

For a while the central bank valiantly defends the peg, raising short-term interest
rates as high as 25 %; alas, the country’s reserves are insufficient and ultimately the
BZD is allowed to float. The exchange rate skyrockets as there are no buyers; no
one wants to hold BZD until the dust settles and the exchange rate moderates. In a
few weeks, the BZD is trading at 3:1 USD.
At this point, speculators come in to take their profits, bringing demand, and the
exchange rate stabilizes. Seeing some measure of stability, investors and those
doing business in Belize return to BZD-denominated assets and slowly drop their
costly hedging transactions. The increased demand boosts the currency toward its
long-run equilibrium level of 2.6:1 USD.
This is a practical example of Overshooting, which occurs whenever a change
in circumstances results in a shift from one disequilibrium point to another disequi-
librium point in the opposite direction, which eventually moderates toward long-
run equilibrium (Fig. 12.14).
The cause of overshooting in this example was the tremendous uncertainty of the
expected exchange rate (ee) prior to the devaluation, as expectations of an imminently
bursting peg ratcheted up selling activity. While there may be a consensus on the
currency’s long-run “fair value,” this means little to the businessperson who needs
to operate in Belize next month or the investor who is responsible for generating
quarterly returns. In a crisis, people generally seek to “play it safe”—and this
means abandoning the currency where possible. However, “momentum-based”
overshooting, while supported by recent research in behavioral economics, is not
the only type.
Rudiger Dornbusch, in his seminal 1976 paper “Expectations and Exchange
Rate Dynamics,” explained how overshooting may occur as a necessary result
when certain variables in a mathematical identity are “stickier” than others; that is,
some variables may adjust instantly, while others take time to adjust. We discussed
328 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Fig. 12.15 Currency

depreciation followed
by inflation

this when comparing the relative slopes of the LM curve and the BOP curve—the
difference in slopes being due to the faster speed at which variables related to
capital (KAB) adjust compared with the slower movement of variables related
to goods and services (CAB).
Recall the formula for the real exchange rate: R ¼ (P*e)/P. We know that real
exchange rates will generally tend toward parity (while rarely, if ever, meeting
strict parity of R ¼ 1). So, a large change in one of the variables will be followed by
a change in another, compensating variable, over time, to return the real exchange
rate to equilibrium. A sudden change in the exchange rate, e, will therefore require a
compensating change in the price level, P. However, exchange rates change near
instantly, while prices are sticky and move much more slowly.
Overshooting due to the difference in the timeliness of movement between the
price of currency and the prices of goods can be illustrated through an ISLM-BOP
Let’s take a country that loses a fight to defend its currency following a BOP
Here in Fig. 12.15 we start with Country A, with a currency peg of 5:1 USD,
under speculative attack with the BOP in disequilibrium (E0 is in BOP deficit).
When the currency peg breaks despite A’s best efforts to preserve it, the currency
weakens (e↑) from 5:1 to 8:1USD and the IS shifts from IS0 to IS1. This adjustment
happens over a short period of weeks or months as the speculative pressures built up
during the currency attack blow themselves out. The economy settles at a new
short-term equilibrium at E1.
Over time, however, the weaker currency makes imports more expensive,
increasing the price of key raw imports and consumer staples, leading to inflation.
As the price level increases (P↑), this causes a shift in the LM curve from LM0 to
LM1. This process takes more time than the exchange-rate adjustment, however, as
even instantaneous price increases from overseas suppliers take weeks or months to
reach consumers.
12.6 Bigger Than Central Banks? Global Investors and the Balance of Financial Power 329

We are once again in disequilibrium as the new goods market–money market

equilibrium E2 (where IS1 and LM1 intersect) is in BOP surplus (SFX>DFX). As
our currency is freely floating, the IS curve does the adjustment into equilibrium,
with the currency exchange rate strengthening (e↓) from 8:1 to 7:1 USD. The IS
curve shifts from IS1 to IS2, and our new equilibrium point is at E3.
So, this example of overshooting saw our exchange rate initially shoot upward,
from 5:1 to 8:1, then strengthen back to a new equilibrium at 7:1, due to a delay
between the adjustments to the numerator and denominator of the real exchange
rate R ¼ (P*e)/P. “Momentum” based on the herd behavior of investors had
nothing to do with it.
In practice, overshooting likely involves both behavioral and structural forces,
though these may be difficult to distill from the data.
In either case, it is important to note that it is independent (primarily institu-
tional) investors and businesspeople, rather than governments or monetary
authorities, who are driving these massive macroeconomic shifts. Often the final
results are exactly counter to what authorities seek to achieve. Just how much power
do the authorities have versus independent financial and business actors in the
global macroeconomy? We turn next to address this question.

12.6 Bigger Than Central Banks? Global Investors

and the Balance of Financial Power

We generally take the power of the central bank for granted. It is “in charge” of our
money, on which its name, and often its image, appear. It sets interest rates, controls
the quantity of money in circulation, and establishes the rules by which the banks
operating under its authority maintain their reserves. When central bankers issue
their often obscure pronouncements, politicians, economists, and investors the
330 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

world over parse their every word for hidden meaning. And no matter what else
happens, the central bank can always simply “print” as much (or as little) money as
it wants.
After all, “You can’t fight the Fed!” But then. . .
• How was it possible during the EMU crisis of 1992 for a few global investors to
overwhelm the power of the Bank of England, one of the oldest and most
powerful financial institutions in the world?
• Why, despite two decades of easy monetary policy from the 1980s into the
2000s, was the Bank of Japan unable to spur economic growth?
• How were entire economies in Southeast Asia overwhelmed by flows of hot
capital in the late 1990s?
• And why was the ECB unable to contain the spread of the European sovereign
crisis of 2010–2011?
At the time official central banks were first established in the West, beginning in
the late seventeenth century, they did in fact represent a significant concentration of
financial power. So much so that the United States, with distrust of central authority
built into its DNA, launched, then closed, two official banks over its first hundred
years of existence before finally establishing the Federal Reserve in a peak era of
progressive activism in 1913, the last major economic power of the era to do
so. Central banks do not lack for power; they typically have independent control
over monetary policy, intervene in foreign exchange markets at will, are the lenders
of last resort to the banking system, and in many countries play a large regulatory
role as well.
And let us not forget that the central bank can, actually, create money at will.23
However, just like the Wizard of Oz, central banks often rely more on their
reputation and image than on actual brute financial force. Their raw power is in fact
more limited than many would assume.24

12.6.1 Size

We can begin by simply looking at the size of the balance sheets of the world’s
monetary authorities relative to those of the world’s private pools of capital.

Or at least out of electrons in the form of bytes of information in electronic transactions.
For the likening of central bankers to the Wizard of Oz we are indebted to John Hussman, Ph.D.,
who wrote that “Alan Greenspan isn’t ‘The Maestro.’ He’s Oz,” in Why the Federal Reserve is
Irrelevant, Hussman Funds Research & Insight, August, 2001, accessed November 18, 2011,
http://www.hussmanfunds.com/html/fedirrel.htm. See also “Superstition and the Fed”, October,
2006, accessed November 18, 2011. http://www.hussmanfunds.com/wmc/wmc061002.htm.
Dr. Hussman’s writings, available at the aforementioned site, are indispensable to those seeking
to understand contemporary financial markets from an analytical and historical perspective.
12.6 Bigger Than Central Banks? Global Investors and the Balance of Financial Power 331


Wealth*: 26
80 Hedge Funds:1.7
Private Equity:2.5
Sovereign Wealth Funds: 3.8
60 Funds: 20.4

40 Mutual
Funds: 22.9

World Monetary Funds:28
Foreign Exchange:
7.7 Gold: 1.3 Base, 13
Central Authorities' Central Banks' Global Assets under
FX Reserves Monetary Base Management

Fig. 12.16 World FX reserves, monetary base, and private assets under management 2009–2010
(in trillions of USD). Private wealth is a net figure of the $39 trillion in privately managed assets of
high net worth individuals less $13 trillion which falls under other categories in the chart. Foreign
Exchange Reserves are held by central banks or government treasuries, depending on the country.
The majority (>60%) are held in US-Dollar denominated assets, with 30% in Euro, and 10% in
other currency-denominated assets, primarily Japanese Yen and British Pounds. The world
monetary base is a fair proxy for the scale of the world’s central banks in the global financial
picture. Total assets of the world’s central banks are perhaps 30% to 50% higher than this figure as
central bank debt and other liabilities add to the total. Nevertheless, the scope of credible monetary
policy does bear a relation to the current monetary base at any given time. (Data sources: Natixis,
Credit Suisse, Boston Consulting Group, TheCityUK)

The world’s central banks and government treasuries held a combined total of
roughly US $9 trillion in foreign exchange reserves in 2010, of which $1.3 trillion
was in gold, and $7.7 trillion was in foreign currency and bonds. The combined
monetary base of the world’s central banks totaled some US $13 trillion.25
These are impressive figures. The combined assets under management (AUM) of
the world’s investors, on the other hand, totaled around $106 trillion.26 Comparing
the scale of the resources at the disposal of official monetary authorities versus
global investors is illustrative (Fig. 12.16).
Clearly there are pools of assets that dwarf the combined resources of all the
world’s central banks. Blackrock, the world’s largest asset manager as of December

Artus P (2011) Do central banks withdraw liquidity they have created? Natixis Flash Markets
Economic Research, February 4, 2011 (Paris: Natixis, 2011)
Marko Maslakovic, Fund Management 2010 (London: UK, October 2010_. See also BCG
Report, Global Asset Management 2010: In Search of Stable Growth (Boston: Boston Consulting
Group, July 2010).
332 12 Capital Flows: Perfectly and Imperfectly Mobile Capital


150.0 Financial
wealth: 98.2


50.0 106.3 Non-financial

wealth, 96.2

9.0 13.0
World foreign Central Banks Assets Under Global Wealth
exchange reserves monetary base Management

Fig. 12.17 World FX reserves and monetary base versus private assets under management and
total global wealth, 2009–2010, USD trillions (Data sources: Natixis, Credit Suisse, Boston
Consulting Group, TheCityUK)

31, 2010, had some $3.6 trillion under management.27 The sum of the assets
managed by this single private entity is greater than that of the People’s Bank of
China, the world’s largest central bank by total assets, as well as that of the (bloated,
as of 2010) US Federal Reserve.
New entities have entered the picture, whose effect on the world’s financial
markets is as yet uncertain. Sovereign wealth funds, pools of government capital
held outside the central bank and deployed for financial gain, have proliferated
since the 1990s. The funds held by the Abu Dhabi Investment Authority (US $627
billion), Norway’s Government Pension Fund Global ($443 billion), and Saudi
Arabia’s SAMA Foreign Holdings ($415 billion) exceed those of all but the world’s
largest central banks.
And, counting “assets under management” only conveys part of the picture. Global
wealth, including both financial assets and nonfinancial wealth such as housing, real
estate, and small business assets, totaled $194 trillion in 201028 (Fig. 12.17).

Blackrock, “About Us,” accessed March 27, 2011. www2.blackrock.com. http://www2.
Global Wealth Databook, Credit Suisse Research Institute (Geneva: Credit Suisse Group AG),
August 2010. Note: Figures for global wealth vary significantly depending on how the studies’
authors accounted for currency effects. While Credit Suisse arrives at a figure of $194 trillion for
2010, the Boston Consulting Group, using a methodology that eliminates certain currency effects,
comes up with a figure of $114 trillion.
12.6 Bigger Than Central Banks? Global Investors and the Balance of Financial Power 333

Should a government or central bank seek to “defy gravity” by maintaining a

policy that runs counter to market forces (e.g., by maintaining an artificially strong
exchange rate), it is clear that the market of global investment funds is sufficiently
large so as to overwhelm such efforts if they persist for long.
In the words of economist Herbert Stein, “If something cannot continue, it
However, despite being outgunned, the central authorities do hold powerful tools
that are denied to non-state actors. Let’s examine the tools at the central bank’s disposal.

12.6.2 FX Intervention

The “FX” lever is a powerful tool by which the central bank may manage the
domestic currency’s exchange rate.
The central bank can artificially create a “strong” exchange rate by selling
foreign exchange and buying up domestic currency. However, this policy is limited
by the bank’s finite reserves of foreign exchange. When it runs out of FX, it’s “game
over” for a strong-currency policy. This scenario has played out in countless
speculative attacks. The bank may borrow FX from other central banks to continue
for a while, but once investors see this happening, the full fury of market forces will
be unleashed against the bank’s efforts. Unless the authorities have sufficient
resources to credibly maintain a defense, as Hong Kong did in the 1997–1998
crisis, their efforts must eventually fail.
A “weak” currency may generally be maintained for a longer period of time, as has
been the case with China for the first decade-plus of this century. This is accomplished
by buying up FX with newly issued domestic currency. The limits of this policy are
eventually reached, however, as the increase in domestic money stock leads inevitably
to inflation and an appreciation of the real exchange rate. “Sterilization,” which we
explore in the next chapter, involves the central bank removing this money through
open-market operations or adjustment to the RRR. This may hold inflation at bay for a
time. Such a policy, however, is highly distortive if maintained for an extended period
as it leads to overinvestment in export-related manufacturing, atrophy among
domestic-focused manufacturers, underdevelopment of the service sector which is a
key component of an advanced economy, and impoverishment of domestic consumers
through the significant dilution of their purchasing power.

12.6.3 Monetary Policy

The “M” lever is another powerful tool, which unlike FX intervention, is not limited
by a finite stock of reserves. Surely such power tilts the playing field in the central
bank’s favor—after all, the authorities can “print money” at will!
334 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

(1) Money demand becomes insensitive to changes in interest rates (h¯),

so (2) increase in M fails to lower rates or increase output.


Rates (2) Increase in M (1) Decrease in (h) changes slope of LM (k/h)
i LM0


Y0 = Y1 (unchanged) Y (GDP)
(1)Shift in intercept
– (1/h)M/P

Fig. 12.18 Liquidity trap

The central bank uses three standard tools to alter the quantity of money in
circulation: open-market operations, adjusting the required reserve ratio, and
setting the discount rate. Unconventional policies, many of which were unleashed
during the post-2007 period, include lending programs to non-bank institutions, the
purchase of longer-dated government bonds, the purchase of government-
sponsored agency securities, and the purchase of private-sector assets.
The central bank may also resort to outright monetization—the direct purchase
of new on-the-run government debt.
There are key limitations to monetary policy, however. These include:
(i) The central bank can influence the supply of money and credit, but it has no
direct influence over the demand for money or credit. We saw this in the
“liquidity trap” example which we briefly examined in Chap. 9. When money
demand becomes insensitive to changes in interest rates, even a significant
increase in money supply will fail to affect output (Fig. 12.18).
Recall the LM equilibrium equation:
k 1 M
i¼ Y þ FX
h h P

The decrease in the sensitivity of money demand to changes in interest rates

(“h”) both increases the slope and drops the intercept of the LM line. This renders
an increase in “M” impotent to generate an increase in output from its original
level. These scenarios normally include a drop in the IS line due to collapsing
confidence, which we have not shown here; this further exacerbates the effect,
12.6 Bigger Than Central Banks? Global Investors and the Balance of Financial Power 335

Fig. 12.19 M1 money multiplier 2006–2012 (Source: St. Louis Fed)

pushing Y lower. A real-world example was evidenced by the severe drop in the
“money multiplier” in advanced countries following the financial crisis of
2007–2009. A huge increase in base money simply sat as idle bank reserves
with few takers among commercial borrowers. The overall total of money and
credit in the economy actually declined despite the explosion in base money
(Fig. 12.19).
Essentially, under certain circumstances, active monetary policy becomes
(ii) “Seigniorage” is the term used to denote the value gained by the central
government by the issuance of new currency into existence. At the time the
currency is first issued, the overall economy has not yet adjusted itself to the
fact of an increased quantity of money in circulation. Thus, the first to have
their hands on this newly issued money (banks, under open-market operations,
or the central government under monetization) will enjoy real purchasing
power which dissipates as the market adjusts its expectations to the new level
of money supply.30

See James Bullard, “Seven Faces of ‘The Peril,” Federal Reserve Bank of St. Louis Review,
September–October 2010 St. Louis: St. Louis Fed, 2010) for a thorough discussion of the
effectiveness of monetary policy during and after the 2008–2009 crisis.
The similarity of these operations to counterfeiting has long been remarked upon. The
counterfeiter, having his hands on the newly printed money before anyone else, gains real
value; as the volume of his notes enter circulation, they add to the money stock and ultimately
dilute everyone’s purchasing power. However, by the time this happens, the counterfeiter, like
the legitimate currency issuer and those closest to it, has already made his gain. For a lengthy
treatment from this perspective, see Murray N. Rothbard, The Case Against the Fed, Ludwig von
Mises Institute, 2007.
336 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

This is an ancient practice with a long tradition. In past millennia, seigniorage

was accomplished by diluting the gold content in various coins or “clipping” the
edges by some percentage and using the clipped portion to create new coins.
However, while the monetary authorities can theoretically “print” as much
money as they want, the utility of this exercise quickly becomes limited as the
public learns to expect a depreciation in the currency’s purchasing power. A limit is
eventually approached in the real value gained through seigniorage,31 beyond
which the policy is self-defeating and leads to monetary and financial collapse.

12.6.4 The Limits of Active Policy in an Open Economy

We have seen in Chaps. 8 and 10 how interest parity and purchasing power parity
dictate that manipulation of the exchange rate will be mitigated, in real terms, by
endogenous adjustment of interest rates and price levels—returning the real
exchange rate back to parity or near-parity.
And, in Chap. 11, we saw how active monetary policy may be counteracted by
both inflation and exchange-rate adjustments (under floating rates) and an outflow
of foreign exchange (under fixed rates).
Thus, the world’s monetary authorities, though backed by the power of their
sovereigns and with seemingly unlimited ability to call money into and out of
existence, are both severely outgunned by global investors with respect to total
financial resources in the marketplace and are in practice somewhat constrained in
their actual ability to directly affect outcomes.

12.6.5 The Source of a Central Bank’s Power

We knew how much of banking depended upon make-believe or, stated more conserva-
tively, the vital part that public confidence had in assuring solvency.
Raymond Moley, FDR Presidential Advisor 1932–1936
“Pay no attention to that man behind the curtain! The Great Oz has spoken!”
- The Wizard of Oz (1939)

The limit is a function of nominal interest rates, inflation, and GDP growth. A discussion may be
found in Willem H. Buiter, “Can Central Banks Go Broke?” London: Centre for Economic Policy
Research, May 2008.
12.6 Bigger Than Central Banks? Global Investors and the Balance of Financial Power 337

Raymond Moley (1886–1975), Associated Press

The most powerful weapons in a central bank’s arsenal are its credibility and the
confidence that the public has in its prudent management of monetary policy. We
have seen the power of confidence to affect economic outcomes in our models, as
shifts in C and I may cause large moves in the IS curve. A central bank’s credibility
is built over time through sound management of the currency and banking system
and by keeping inflation contained.
Central bankers know better than anyone the actual limitations of their policy
tools when deployed against the vast forces of the market. Their efforts therefore
are largely directed toward managing expectations, in the hope of affecting market
sentiment—so that the market will voluntarily move in the desired direction or at
least soften its resistance. The pronouncements of central bankers are deliberately
obscure, leaving room for interpretation, as explicit statements may “pin down” the
monetary authorities, reducing their flexibility for action and potentially harming
their credibility should events move in a manner contrary to their statements.
The veil of secrecy over many of the activities of the central bank aids its efforts.
The exact nature of its foreign exchange interventions, discount-window lending,
and internal deliberations are often kept secret from the public, who are left to parse
every utterance of the bank’s representatives in the manner of Sovietologists of old
studying the position of various Politburo members in the parade stand on Red
When a central bank telegraphs its intention to hold interest rates low “for an
extended period,” for example, investors will hesitate to bet against that outcome.
A “crawling peg” works in much the same way—if the authorities indicate a
planned, gradual depreciation of a strong currency, investors will be less likely to
bet on a sharp break, even if the planned depreciation still leaves the currency
stronger than market rates would dictate.
Confidence is a fragile thing and takes years to build. And it can be destroyed
very quickly.
338 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

12.6.6 The Straw That Breaks the Camel’s Back

Despite the vast aggregate sum of financial resources commanded by the world’s
investors, only a small fraction consists of “hot money” or potential hot money.
The world’s 7,000 or so hedge funds, which represent a significant portion of the
world’s potential “hot money,” only manage around US $2 trillion combined, with
“global macro” strategies representing perhaps 20 % of the total.32
Speculative attacks, discussed in the section above, are generally spearheaded by
this relatively small pool of capital. How then are they so often successful?
The key is the asymmetry in the way people evaluate potential gain and loss.
Positive feelings, including the confidence which the central bank seeks to build
brick by brick, take a long time to develop. Investors are constantly on the lookout
for threats to their capital—this is why, for example, stocks are said to climb “a wall
of worry” when they are rising. Fear, however, is powerful and contagious, and
market declines are almost invariably much sharper and more severe than gains.33
Relatively small amounts of hot money piling on against a currency peg can have
the same effect as yelling “fire” in a crowded theater; investors tend to run for the
exits to avoid even the chance of being burned.34 Larger, slower-moving pools of
capital, observing the speculative bets, will check their risk exposure and may take
action to protect themselves. Even long-term investors in the domestic economy
may become concerned enough to hedge their currency and other exposure, and
global firms may begin to shift production and resources to other countries.
A central bank attempting to maintain a policy at odds with these movements,
whether in exchange rate or monetary policy, will quickly find itself facing an
increasing number of forces arrayed against it.
In the long-run, market forces invariably prevail, though prudent fiscal and
monetary policy and deft management of expectations can successfully ward off
the adjustment for long enough that other factors come to reshape market pressures.
Moreover, extremes of euphoria and fear are fleeting, and the monetary authority
may successfully maintain its policy long enough for passions to cool and reason to
reassert itself. A country might “buy time” for its domestic industry to recover from
a sharp recession with a period of normally non-sustainable monetary policy;
likewise, the disruption from an impending currency crash may be held off long
enough for a country to get its fiscal house in order to provide underlying strength to
the currency. And, at times, investors may simply be wrong about a perceived

As of 2008 per RaisePartner Quantitative Portfolio Management, “Global Macro Strategies:
Fundamental Expertise and Quantitative Modeling,” The Quant Corner November 2008 (Paris:
Raisepartner, 2008), accessed March 27, 2011, http://www.raisepartner.com/lexique/files/
The best treatment ever on this subject is Charles Mackay’s 1841 classic Extraordinary Popular
Delusions and the Madness of Crowds, which we mentioned in Chap. 11. A modern classic is
Charles Kindleberger and Robert Aliber’s Manias, Panics and Crashes: A History of Financial
Crises, Sixth Edition (Palgrave Macmillan, 2011).
The old adage applies: “If there is going to be a panic, it’s best to be first!”
Articles 339

weakness, and the bank may succeed in holding off the onslaught for long enough
for these misperceptions to correct themselves.
Central bank efforts to implement and maintain their desired policies are part of
a battle that plays out every day in the marketplace through hundreds of billions of
dollars’ worth of transactions.


Article 12.1. The Sarangam Economy: A Retrospective

Dr. Peter Parks, East Brunswick Economic Review

The “happy years” were indeed happy. Things were good all over for the Sarangam
economy with its openness to foreign capital and fixed exchange rates; housing,
jobs, the stock market, interest rates, food prices, even the weather had cooperated.
But then after about four euphoric years in which books such as “The Sarangam
Century”, “Behold the Sarangam Economic Miracle”, and the enticing, “100 Ways
to Invest in Sarangam and Get a Slice of the Pie” dominated the best-seller lists,
cracks began to appear.
At first the warnings sounded like a peevish naysayer’s ramblings against an
economy that was the poster child for macroeconomic growth. But then the lone
sirens began to have company. More and more analysts began to notice the cracks
that mysteriously appeared and then grew quickly into myriads of fault planes.
Suddenly the “growth” was being dismissed simply as “not real” and mainly as
asset price bubbles. Sarangam’s exceptionally tall Paradise Tower was lambasted as
the “Tower of Babel—an unintelligible project.” The country’s new aircraft carrier
program was derided as “the fleet built for tourism,” and President Me King Ling’s
fourth palace—this one made of exquisite malachite imported in special barges
from the Ukraine—was fodder for late-night talk shows.(a)
The macro outlook suddenly crumbled when it became evident from Finance
Minster Me Noking’s comments that the peg would be difficult to sustain if foreign
investors and foreign investment houses kept frantically pulling their money out of
Sarangam. It was even rumored that the legendary financier Jorge Sideous was
placing massive one-way bets against the currency.(b) With the currency under
severe pressure, and with the economic outlook dropping remorselessly, the Central
Bank of Sarangam finally de-pegged the local currency, the Mekong, and saw it
depreciate immediately by 35 %. (c)
It seemed that the rapidly depreciated currency would actually pull the country
out from its self-made mess by stimulating its exports, (d) but then after about
4 weeks the inflation became impossible to ignore—in fact, it was crippling. Output
slumped back down as the currency appreciated by roughly 15 %, and interest rates
that had shot up with the rise in prices following the devaluation subsided to some
340 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

By the time the dust had settled, final output growth was pretty much where it
was before the big devaluation, but interest rates remained stubbornly high along
with the residual inflation, which seems to be a legacy of the “Happy Times” that
Saranganians are now trying to forget.

Hints and Solutions

Article 12.1

(a) Sarangam has obviously enjoyed an economic boom that has gone too far and
has included speculative asset price bubbles. Generally such a boom would
include “cheap money,” interest rates maintained too low for too long, and a
surfeit of hot capital flows finding their way into riskier and riskier assets.
At the point where the imminent collapse of the bubble becomes obvious, as
it has here, we will see a significant drop in the long-term macroeconomic
outlook for Sarangam (Pr↓).
The BOP rises as Pr falls—we find ourselves in BOP deficit (DFX>SFX) at
point E0 in Fig. 12.20 below.
Here, we face the prospect of a hard landing as FX flees the country, pushing
the LM line back to LM1.
(b) Jorge Sideous is launching a speculative attack on the currency—which he
would undertake by:
(i) Borrowing in Sarangam’s currency
(ii) Selling the borrowed currency at its present conversion rate and investing
the proceeds in his domestic currency

Fig. 12.20 Declining macro

outlook (Pr↓), fixed rates,
Hints and Solutions 341

Fig. 12.21 Given declining

macro outlook (Pr↓), fixed
rates, PMK: proceed to
weaken the currency

(iii) Waiting for Sarangam’s monetary and political authorities to succumb to

the pressure and break their peg, or at a minimum revalue at a weaker
exchange rate
(iv) Upon the devaluation, convert his domestic currency into Sarangam cur-
rency and repay the original loan
Sideous’ profit would come from the gain made on the devaluation (iv), plus
whatever interest he earned on his invested funds from (ii), less whatever
interest he had to pay on the borrowed funds (iv).
(c) The central bank’s move will ensure that the shift into general equilibrium will
be done by the IS curve through the weakening of the exchange rate (e↓), rather
than by the LM curve as was the only option under fixed rates (see [a], above).
So, the IS curve shifts from IS0 to IS1 to attain E2 as we see in Fig. 12.21.
Here, we have avoided the hard landing (for now) and spurred exports, but we
have also activated the forces of inflation.
(d) As the currency depreciates, exports become cheaper and output, therefore,
increases. We can see this if we drop the X and V curves below the ISLM-BOP
curve, as we do in Fig. 12.22.
We started the X and V curves in hypothetical positions where Sarangam
initially had a current account deficit (“CAB-”on the graph), and with exports
growing and imports shrinking in response to the weakening exchange rate, the
current account deficit has been erased and is now a surplus. (This is not a
necessary result—it would depend on the initial positions of the X and V
curves. The consistent result, however, will be an increase in the CAB from
its starting point).
(e) Here we have prices increasing (P↑) so LM snaps back to LM1 to a new IS–LM
intersection at E3. The BOP surplus condition (SFX>DFX) is resolved by a
strengthening of the now-floating currency (e↓), and the IS then drops back to
IS2. The economy ultimately comes to rest at equilibrium point E4 (Fig. 12.23).
Sarangam is left with reduced output from the exorbitant levels seen imme-
diately after the depreciation at Y1, but still higher than it was originally.
342 12 Capital Flows: Perfectly and Imperfectly Mobile Capital

Fig. 12.22 Given declining

macro outlook (Pr↓), fixed
rates, PMK: results from
weakening the currency,
including effects on imports
and exports

Fig. 12.23 Given floating

rates, PMK: inflation and
strengthening currency
following a sharp

Thanks to the modest rebound in the strength of the currency—a classic

example of “overshooting”—interest rates moderate from where they would
have been at E3. Interest rates and prices, however, remain elevated from what
they were before the episode began in (a) above.